For most people, filing taxes is a simple matter of putting a bunch of numbers into TurboTax, finding out they get some money back, and not giving it a second thought. In this post I hope to explain the basics of the US federal income tax system in simple terms as it applies to most people and list a few FAQs about taxes.
If you see something that isn’t correct or have suggestions on other things to add, please let me know in the comments or by private message. Be sensitive that this is intended as an overview and not line-by-line instructions on how to file one’s taxes. For detailed tax questions you should see a tax professional.
ELI5: Taxable Income, Tax Brackets, Marginal Tax Rates
The biggest point of confusion for a tax novice is how the tax brackets affect their tax burden. Your marginal tax rate and your effective tax rate are not the same thing. Moving into a higher marginal tax bracket does not mean your entire income is taxed at that rate.
The marginal tax brackets for 2013 are listed here (2014). I will use the single filing brackets for illustrative purposes (I also didn’t include deductions for this initial example).
Say you’re a single filer that has $34,000 in taxable income (taxable income is explained more in-depth later). Your boss calls you in and tells you that you’re getting a raise to $40,000 per year! Great! But… how does this affect your taxes? At $34k you’re just under the cutoff for the 25% tax bracket, and now your marginal tax rate is 25% after the raise. Are you really “making” more money, but losing virtually all of it to the increased tax burden?
No. Since the tax brackets are marginal, based on the marginal tax rate (the tax rate at which the next dollar you earn is taxed), only the amount above the 25% bracket threshold ($36,901) is taxed at 25%. Your tax calculation looks like this:
- $8,925 at 10% = $892.50 ($8,925 in taxable income)
- $27,325 at 15% = $4098.75 ($36,250 – $8,925 in taxable income)
- $3,750 at 25% = $937.50 ($40,000 – $36,250 in taxable income)
- Total tax = $5,928.75, effective federal rate = 14.8%
The marginal tax rates only apply to taxable income – that is, your income after all of your deductions and exemptions are factored into your total income. Your total income is listed in line 22 of the 1040 form, while your taxable income is listed in line 43 of the 1040.
Deductions: Standard, Itemized, above the line – WTF?
Everyone is entitled to deduct certain things from their taxes. Deductions reduce the amount of income that is subject to tax – they reduce your taxable income. Deductions fall into three major categories: the standard deduction, itemized deductions, and “above the line” deductions.
- The standard deduction in 2013 is $6,100 for single filers in tax year 2013 ($6,200 for 2014). If you claim the standard deduction, this is what you’d put in line 40 of Form 1040.
- If you want to claim itemized deductions, of which a number of expenses qualify, you need to include Schedule A with your tax filing. The total of your itemized deductions goes in line 40 of the 1040 form. The major itemized deductions are for home mortgage interest, state/local/property taxes, and charitable donations.
- “Above the line” deductions are listed in lines 23-35 of the 1040. Most require additional documentation to show eligibility. In /r/personalfinance the most popular tend to be the student loan interest deduction (line 33) and the IRA deduction (line 32).
One of the most common tax questions we get here is “Should I itemize my deductions or just take the standard deduction?” If the sum of your itemized deductions is not larger than the standard deduction, you’re almost always better off claiming the standard deduction.
Now let’s go back to our simple example from before. Taking into account the standard deduction and one personal exemption for a single filer, the tax calculation changes significantly for the better:
- $6,100 + $3,900 = $10,000 subtracted from your taxable income.
- $8,925 at 10% = $892.50 ($8,925 in taxable income)
- $21,075 at 15% = $3,161.25 ($30,000 – $8,925 in taxable income)
- Total tax = $4,053.75, effective federal rate = 10.1%
Notice that the standard deduction and personal exemption put you in the 15% marginal tax bracket instead of the 25% bracket.
Your state may offer its own tax deductions for state taxes. Details vary by state, but one of the most valuable is the deduction for 529 plan contributions if your state offers it.
In addition to deductions, most taxpayers are entitled to claim one or more tax exemptions. Exemptions, like deductions, reduce your taxable income. The personal exemption is $3,900 for 2013 ($3,950 for 2014). If you are married filing jointly you can claim an additional exemption for your spouse. You can also claim an additional exemption for each dependent.
High income individuals and couples may run into the phaseout thresholds for the exemption(s) they claim. For more, see IRS Publication 17.
Your employer is required to withhold taxes from each of your paychecks by law. The formula for withholding can be found in IRS publication 15. You can adjust your withholding by giving a new/modified W-4 form to your employer. The W-4 allows you to specify the number of allowances or extra withholding from your paycheck.
The IRS also provides a somewhat useful withholding calculator that can help you determine if you are withholding too much or too little from your paychecks. The calculator is good if you have a regular salary that doesn’t change much throughout the year.
Tax “refunds” – Not Ideal
Your tax filing calculates your actual tax obligation to what you’ve had withheld throughout the year. If you underwithhold, you will owe the IRS the difference. Beware that if you purposely underwithhold too much, you may face a penalty.
If your tax obligation is less than what you’ve had withheld throughout the year, the difference is returned to you as a “tax refund.” While it may seem counterintuitive, tax refunds are not a good thing. “Refund” implies that you actually owed the money you paid at some point – this is not the case. Money that you never owed was being held by the government at 0% interest. Instead of working for you throughout the year by paying down debt or funding your retirement accounts, your money was effectively doing nothing for anyone. Aiming for as small a refund as possible, or even owing a small amount, is highly advisable. You can do so by adjusting your allowances on your W-4.
Tax credits directly reduce your tax burden by effectively giving you a refund. There are dozens of tax credits in the tax code. Some of the more common, subject to eligibility, are the child care credit, foreign tax credit, American Opportunity tax credit, and Lifetime learning tax credit. Your state may offer tax credits as well.
Capital Gains and Capital Losses
Another common point of confusion is the capital gains tax rules. Due to the character limit, I will direct you to this page from About.com which explains things very well.
You cannot claim unlimited tax-free long term capital gains in the 15% tax bracket – only the amount required to “fill up” the 15% bracket is exempt from tax. Any long-term capital gains past that would be taxed at the 15% rate.
Several other taxes you will or may be responsible for paying, and will see withheld from your paycheck:
- State/local taxes – rates vary by state and locality.
- Old Age, Survivors, and Disability Insurance – 6.20% up to $113,000 in taxable income in 2013, 6.20% up to $117,000 in taxable income in 2014.
- Medicare – 1.45% on your entire taxable income. If you are a high earner you may have to pay an additional 0.9%.
Frequently Asked Questions about Taxes
Should I see someone about my taxes?
Even if you’re itemizing your deductions, the majority of people that ask this question in /r/personalfinance are likely capable of filing their taxes themselves. Tax situations that may merit seeing a professional would be a small business, multiple state residencies/income, or overseas tax issues (foreign tax credit, foreign earned income exclusion). Tax preparation costs vary based on complexity and where you live, but most tax returns can be prepared by a professional for a few hundred dollars.
What tax software should I use?
TurboTax and TaxACT are the two most popular commercial suites. If your income is below $58,000 you can file your federal return for free directly with the IRS using freefile. Costs of state returns through the Turbotax and TaxACT cost $36.99 and $17.99, respectively. Both suites charge more for things like capital gains, rental income, etc.
I already filed my taxes. Can I still contribute to a Roth IRA?
Yes. Unless you’re eligible for the saver’s credit then your Roth contribution after you file your return but before the April 15 deadline will not affect your tax filing. Roth contributions are post-tax.
Why doesn’t the student loan interest deduction double for couples married filing jointly?
That’s just the way the tax code was written. The maximum you can deduct in student loan interest is $2,500 regardless of your filing status.
What’s the difference between a tax deduction and a tax credit?
Tax deductions reduce the amount of your income that is taxed, while tax credits reduce your tax burden directly. The amount your tax burden is reduced by a deduction is the amount of the deduction times your marginal tax rate. For example, a tax deduction of $1,000 for someone in the 25% tax bracket will save $250 on their overall tax burden. A tax credit of $1,000 will save $1,000 on their overall tax burden.
I screwed up a tax return for a previous tax year. What should I do?
You need to file an amended return, form 1040X. The IRS provides this guidance for filing amended returns. As the IRS notes, your state tax obligation may change based on your federal tax obligation. You may need to file an amended state return as well.
Taxes can be intimidating if you’ve never done them before, but most filings are fairly simple. Hopefully the information above answers some of your questions about the basics of the US tax system – please use the comments if you have additional questions.
Edit 04/12/2014: The Tax Policy Center has a great interactive Form 1040 and Schedule A page, in which you can get a brief summary of each line of the 1040/Schedule A by rolling your cursor over it.